News of the Week (January 3-7)
SoFi Technologies; Upstart; Green Thumb Industries; The Boing Company; Microsoft & Planet Fitness; Cannabis News; My Activity
1. SoFi Technologies (SOFI) — What a Bank Charter Would Mean
Last year, SoFi received conditional approval for its banking charter. Final approval is expected to be coming any week now, so I wanted to briefly cover why this charter is so important for the company.
The first benefit is clear — a bank charter will lower SoFi’s cost of capital. The firm uses warehouse facilities to finance loans which are more expensive for it vs. using its own deposits to do so. A bank charter would allow SoFi to use these deposits which would save the company roughly 2% in cost of capital according to CFO Chris Lapointe.
But the benefits do not stop there. A banking charter would also free SoFi to set its own account rates vs. relying on a swap partner like it does today. Thanks to SoFi’s powerful cross-selling capabilities (and now the 2% cost of capital reduction), it can afford to offer its users higher rates of interest on these accounts vs. what substitutes provide. Amid a swarm of fintech competition, this will help the company to profitably differentiate itself.
We also have to remember that SoFi has a significant business to business (B2B) branch of its operations — Galileo. Galileo calls fintech giants like Robinhood and Chime clients. These are not banks and therefore also need swap partners and bank sponsors to facilitate certain activities. SoFi would be able to become this sponsor and — better yet — can cross-sell the service with Galileo’s payment processing software to profitably offer its partners better deals than the field.
SoFi’s lending business would also enjoy far more uniform regulation and therefore incremental product/service consistency. Today, it’s lending segment is regulated by 50 different state agencies. With a charter, it would only be regulated by the FDIC, Fed and OCC to cut through a significant portion of bureaucratic red tape. This exemption also uncaps mortgage volume limits imposed by certain states. With a charter, SoFi would be unlimited in its mortgage origination abilities and would also be able to retain any of these loans on its balance sheet for a longer period of time — thus creating a more consistent stream of net interest income.
To put it plainly, a bank charter would be a big deal for the company and should be coming soon. SoFi has already named Chad Borton — previously USAA’s Bank President — as the new President of SoFi Bank.
2. Upstart (UPST) — Capital Market Activity
a. Why Capital Markets?
A lot has been made about Upstart’s use of capital markets to fuel its growth in recent weeks. I’ll cover the actual securitization process in detail when I publish my Upstart deep dive later in the month. For now, I wanted to give a more condensed summary on why the company leans so heavily on these markets today and why it doesn’t bother me.
The first loan origination that Upstart facilitated solely through its own platform happened 6 years ago. This is still an extremely young endeavor. It’s nice for the company to tell banks and credit unions that it can improve loan book quality and size, but these institutions (especially banks) are heavily regulated and generally conservative with on-boarding new technology. Without a treasure chest of evidence on Upstart’s underwriting ability actually being superior — AI-powered unsecured personal loans are a tough sell. So instead of waiting for banks and credit unions to embrace the somewhat intimidating evolution that Upstart brings, it sought capital markets to build that coveted base of evidence more seamlessly.
Institutions like hedge funds have a unique ability to distribute credit risk in liquid markets. This ability made them inherently more open to welcoming Upstart’s incremental volume. As a result, for now most Upstart-sourced loans are originated by banks like Cross River or FinWise and then immediately re-purchased by Upstart (using trusts) for sale into capital markets. Over the first 9 months of 2021, 76.6% of Upstart-sourced loan volume went through this process. That decision allowed the firm to de-couple its own growth from partner willingness to retain loans on their own balance sheets and is why the company has had such a positive 2021.
But still, I’d like and expect to see more loans being retained by banks. Why?
Upstart’s fees equated to nearly 7% of the origination volume that it sourced in this last quarter. The hefty take rate is born from its ability to deliver loss ratios that adequately outperform expectations. This puts a lot of pressure on the company’s AI-models to provide consistent relative success. An acceptable level of this relative success is tougher to deliver for loans passing through capital markets vs. being retained by banks for a few reasons:
First, banks have access to lower cost of capital which makes their loan businesses inherently more profitable. Generally speaking, this enables Upstart to acceptably charge more in fees.
Second, in order for Upstart loan demand to hum, every single piece of the participating value chain needs to profit off of its loans. There are more pieces of this chain when capital markets are involved vs. when banks are retaining.
Participants needing to profit when banks retain loans:
Participants needing to profit when banks enter capital markets
Originating and selling bank
Institutional Investors in pass-through certificates or whole loan purchases
Institutional Investors in loan pools re-packaged into asset backed securities
The originating and selling bank, the institutional investor and any future players in asset-backed securitization transactions are only participating because it’s a good business decision. If cash flows for capital market participants stop outpacing costs, this demand channel will disappear or Upstart’s take-rate will fall. Nobody would pay Upstart nearly 7% if profits didn’t materially exceed 7% of origination volume.
Beyond a more defensible take rate, some of the savings from a lower cost of capital are passed on to consumers via a lower annual percent rate (APR). This fuels higher conversion, heavier volume, more partners and therefore a compelling network effect.
The process of shifting loans going through capital markets to bank balance sheets will take time and the proportion of loans entering capital markets has been relatively stable for Upstart throughout 2021. Co-founder and CEO Dave Girouard expects the company to close in on 100 bank and credit union partners by next year (vs. roughly 30 today) which would surely help. Other signs like banks consistently raising Upstart budgets and even dropping the FICO requirements they’ve had in place for almost 50 years point to more and more confidence in the model.
The most important thing is that Upstart continues to provide pools of loans to institutions with loss ratio outperformance. This will power acceptable residual cash flows and will motivate partners to retain more loans.
b. Macro Help
Stimulus checks aiding industry loss ratios and historically high deposit levels for institutions are leading some to question if Upstart’s loan outperformance and success is unique to our current environment. It will be imperative for Upstart to prove it isn’t reliant on macroeconomic tailwinds for its success, but instead on the superior nature of its platform.
We have KBRA and DBRS Morningstar surveillance data from pre-pandemic times depicting Upstart’s loan outperformance in that environment. This makes me optimistic but only time will tell. Below are three of many examples of Upstart featuring loan pools that outperform cumulative net loss (CNL) estimates and triggers for its capital market investors — this is a consistent theme.
The positive data shown above does two things: motivates continued capital market demand, and provides concrete evidence to prospective partners on the true utility of Upstart’s AI-models across various macro-backdrops. Now, the firm doesn’t need to go to an established bank or credit union and ask for a leap of faith — it merely needs show them the 3rd party data.
P.S. — While the price action for Upstart has been nothing short of brutal, the company’s fundamental performance continues to be excellent, the valuation is more than reasonable and I will continue to add to my stake.
3. Green Thumb (GTBIF) — Minnesota
Green Thumb entered the Minnesota medical market last week with its acquisition of Leafline. Leafline owns 1 of just 2 vertical state licenses and boasts a production facility with 5 dispensaries in the state plus options to open up 3 more. Minnesota is home to 6 million Americans and Green Thumb will now operate in 15 states upon the deal’s closure.
4. The Boeing Company (BA) — New Order
Allegiant announced plans to purchase 50 737 MAX planes from Boeing between 2023-2025. The contract also comes with an option to buy up to 50 more for a total of 100. Allegiant’s fleet has been all Airbus up until this point meaning this is a real sign of confidence in Boeing (and the power of existing in a supply-constrained global duopoly). The MAX burns 20% less fuel than Allegiant’s fleet on average.
5. Planet Fitness (PLNT) & Microsoft (MSFT)
I liquidated my positions in Planet Fitness and Microsoft during the week. Both holdings have handsomely outperformed my benchmarks and are expensive based on historical multiples.
This was mainly a matter of me wanting to raise more cash to enhance my flexibility with accumulating into more and more multiple compression elsewhere. There are no red flags to report for either company.
6. Cannabis News
Ayr Wellness has now completed around a fifth of its 5% share repurchase program. The company accelerated its purchasing activity last month to take advantage of the volatility.
b) Industry News
California earmarked $100 million to help facilitate permanent cannabis licensing (vs. the temporary provisional licenses many currently have) and the development of legal markets in the state.
A politician in Kentucky — Representative Jason Nemes — proposed a new medical cannabis bill this week. Nemes has tried a few times to pass cannabis reform through his state’s legislative bodies — but without success. Now, he is catering to fellow politicians by removing pieces of the bill that would allow for consuming raw flower or growing at home. Qualifying conditions are expected to be comparatively restrictive vs. other states if the bill passes. There remain several opposers to any kind of reform in the state’s Senate.
Illinois cannabis sales rose 14% month over month in December 2021 to $138 million. This represents a new record.
7. My Activity & a Macro Note
My cash position began the week at roughly 13% of holdings. After liquidating Microsoft and Planet Fitness as well as adding to several existing holdings, my cash position ended the week at roughly 19.1% of holdings. I fully intend to continue to deploy capital into more volatility — but to be candid I’m expecting more of this volatility. The combination of anticipated interest rate hikes and Fed balance sheet shrinkage will create a tighter monetary environment and more heavily discounted future cash flows. These realities have hit the speculative growth assets (like I predominately own) and could continue to do so.
As I’ve previously discussed, I do believe that supply chain and year over year inflation comp normalization will erode monetary policy fears over time — but that may take a while. The bad news is that this might be a turbulent period. The good news is that my holdings continue to thrive and compound at a rapid clip. Eventually, stock performance will mirror this fundamental success. For now, the coil is simply winding up more and more for returns down the road and I am slowly taking advantage of the enhanced risk/reward. That is how I see things.
I added to the following companies during the week: